Fund admin: In house or out?

GP number one is one of the elder statesmen of Asian private equity. In operation since the late 1980s, it has raised six funds, the most recent of which closed at nearly $1.5 billion. GP number two is a country-focused manager that has raised three funds since 2003, the first two largely friends-and-family affairs, while the third - which came in at less than $200 million - includes a sprinkling of institutional investors.

Two firms, with vastly different asset pools and histories, with one thing in common: they prefer to take care of fund administration in house rather than outsource it to a third-party provider.

GP number one has a finance team of approximately 10, more or less the same size and with roughly the same personnel as a decade ago. Outsourcing has been considered in the past, but ultimately dismissed. "We weren't entirely comfortable with the services being offered," an operations executive says. "With our experienced in-house team, we were not willing to give up the control over our data and communications with our investors."

GP number two's finance team is smaller - the CFO plus two fund administrators - and the firm has so far chosen not to outsource because it didn't make economic or practical sense.

"Our funds haven't been that big and a lot of our LPs, particularly in the first fund, were more close associates. We didn't really require a fund administrator and the fund sizes didn't warrant the cost," an executive at the firm explains. "On our next fund some of the larger pension plans may insist we use an administrator and by then the size may warrant paying that extra $100,000-200,000 per year."

Beyond areas such as custodian services, to outsource or not to outsource is traditionally viewed in the context of size, resources and habit. A start-up manager might not need to engage an administrator, but once he reaches a certain scale there are too many funds, with too many investors and portfolio companies for a skeleton internal team to handle. Does he outsource or add to the in house team?

Anecdotal evidence suggests that private equity managers trail their hedge fund colleagues in terms of willingness to outsource, and Asian managers trail their counterparts in North America and Europe.

The question is whether this template still holds true, and if so, for how much longer. Investor bases are becoming more international; investors seek larger amounts of information from portfolio managers; and increased regulation is placing more pressure on back office operations. Service providers vary in terms of the importance they attribute to each of these factors, but they insist times are changing.

"We are seeing Asia catch up to the rest of the world in terms of the general institutionalization of the GPs as well as the LPs and therefore their interests are aligning with global interest in wanting consistency, standardization, automation and cost effectiveness in their operations," says Dan McNicholas, head of sector sales for alternatives in Asia at State Street.

Additional comfort

While McNicholas sees change driven from both sides, LP and GP, others claim the LPs are pushing harder. According to Julian Carey, managing director at Tricor IAG, certain investors out of the US and Europe steer clear of funds without third-party administrators. Sometimes he is contacted by LPs directly, inquiring after the Tricor IAG's systems and compliance as part of due diligence on a client GP.

In this context, signing up a brand name administrator could pay dividends on the marketing trail. But industry participants argue that the reality is more nuanced - certain administrators may support a fundraising but their absence wouldn't necessarily break it.

"What we are seeing is investors spending a lot more time conducting due diligence on the operational side of GPs," says Michael Henningsen, managing director at placement agent Park Hill Group. "A lot of the big advisors and LPs have separate operational questionnaires and they want to know who is responsible for each function of the back office. They want to meet with the CFO and spend time with them and any in house accountants."

Rather than insist on a third-party administrator, the onus is on ensuring that a GP's back office is suitably independent and able to deal with reporting requirements. Small and first-time managers that don't have in house capabilities are therefore nudged in the direction of service providers. These GPs are often led by deal makers who don't come from an administration background and see every day spent handling paperwork in terms of potential investments foregone.

At the same time, the step up from Fund II to Funds III and IV can indeed be onerous, simply because there is a semblance of a track record and this attracts more sophisticated investors. While a local family office might focus purely on absolute returns, the likes of pension funds are interested in IRRs, cash flows and geographic distribution as well - and they want to receive this information in a timely fashion and in a consistent format.

For example, Hony Capital's first fund had only one investor - parent company Legend Holdings - and the second and third are said to have attracted no more than 25 LPs between them. Come Fund IV in 2008, investors were flocking to the GP in their dozens, including the likes of California State Teachers Retirement System (CalSTRS) and Canada Pension Plan Investment Board.

"When you make that leap you go from three people in the finance team being fine to three people being anything but fine," says Andrew Ostrognai, a partner at Debevoise & Plimpton. "There have been a number of times when in the middle of negotiations we are presented with all these requests for bespoke reporting and it really does become a question of whether the back office can handle it."

Ostrognai says that his larger clients generally do administration in house while the smaller players outsource it.

The right size?

If the sub $200 million manager finds outsourcing uneconomical and the multi-fund, multi-strategy GP has sufficient fee income and complexity to build a team internally, this should leave a middle ground - GPs making that leap to Funds III and IV - that are prime targets for the third-party administrators.

The administrators endorse this, but only up to a point, noting that in private equity there is no "generally."

First, the costs of outsourced fund administration can be charged to the fund whereas an internal team is financed from the GP's own reserves, a situation that is said to be increasingly appreciated and exploited by Asian managers of all sizes.

"A lot of GPs don't realize that LPs are happy to pay for the fund administration," says Tricor IAG's Carey. "As far as the impact on IRR is concerned, the administration fee is negligible. You are talking 5-10 basis points of the total committed fund value."

Second, not all large private equity firms are happy keeping admin functions in house. Efficiency and cost are the primary considerations. A GP might be dealing with hundreds of investors in different jurisdictions, each of which requires an element of tailored reporting. Using a global administrator, with processes and technology platforms familiar to all parties, can make the information easier to digest and analyze.

Costs fall into two categories: rising salaries for experienced administrators and rising real estate rentals; and then the opportunity cost of having executives focus on financial reporting when they might be pursuing deals or working with portfolio companies.

"Once a manager gets to a large number of funds they are probably able to build the resources in house," says Alexander Traub, managing director for Asia at Augentius. "But is the manager in fund management or fund administration? Most firms that outsource to the right people the first time choose to focus on fund management and leave the administration with the specialists."

Michael Li, product head for private equity services in Asia Pacific at Citi, recalls a recent conversation with a sophisticated manager in Singapore with a well established back office. Out of the blue the manager started asking about potentially outsourcing all the administration, citing costs.

Li adds that, in Hong Kong in particular, relatively few in the industry have gone through the full lifecycle of a fund, which makes building and retaining a professional in-house team that bit harder.

However, there are mixed views among GPs as to the point at which using a fund administrator begins to have a significant impact on workload. Stephen Tang, CFO at China-focused GP Lunar Capital, argues that, regardless of what might be outsourced, a private equity firm still needs to grasp what is going and therefore requires internal staff.

"You always need a core team of finance people to do the day-to-day work - even just to liaise with the fund administrator you probably need one person," he says. "When you have more than 100 LPs or multiple platforms there may be a practical need for a fund administrator, but we can't reduce headcount by outsourcing."

James Stewart, COO at Headland Capital Partners, adds that even with two active totaling over $2 billion in capital under management, the internal team is well equipped to handle all of the requests for information received from LPs. In the past few years, Headland has made its quarterly reporting more exhaustive, largely in line with the Institutional Limited Partners Association's (ILPA) disclosure recommendations, with more detail on portfolio companies and fund financials.

"We have certain LPs that want their capital account statements within 2-3 days and valuation information very soon after each month end and we are happy and able to deal with those requests" he says. "Communication with our investors would never be outsourced".

Breadth of remit

It is worth noting that a fund administrator's impact depends on the breadth of the remit. Several providers say education is part of their work in Asia. They describe less experienced GPs that have previously not thought deeply about their back office seeing them in action and appreciating this is what they should have been doing all along.

"There are still funds set up in the Cayman Islands that have one board meeting a year to approve the accounts and that's it. All other activities go completely unapproved and unrecorded by the GP board," says Tricor IAG's Carey. "What you wait for is a realization that corporate governance is important and adds substance to what you are doing."

In some cases, progress can literally be measured in terms of boxes ticked. When a prospective client sits down with State Street they are presented with flow chart detailing the various administrative processes and pick the ones they want to outsource.

Managers have different comfort levels - in their ability to see the value in completing a task, in their ability to complete it themselves, and in their willingness to pay a third party to do it for them. They are free to draw the line where they see fit. It starts at light touch accounting and investor reporting and then stretches into portfolio analytics, treasury functions, and corporate administration services.

In the last couple of years, regulatory guidance on the US Foreign Account Tax Compliance Act (FATCA) and the EU's Alternative Investment Fund Managers Directive (AIFMD) has also been in demand. Private equity firms can and do go to law firms and accountants for advice on these issues, but they are still areas in which fund administrators can invest in building competency and thereby differentiate themselves from the rest of the market.

One of the developments in recent years is that has arguably given administrators a bad name is the proliferation of service providers, an inevitable consequence of the proliferation of GPs in Asia. Needless to say it has created volatility in the lower echelons in the market, characterized by intense price competition and compromised quality.

"Five to seven years ago there weren't many fund admin-type operations in Asia but a lot have opened up," says Vincent Ng, a partner at placement agent Atlantic-Pacific Capital. "There are global and local specialists and also a number of firms that previously didn't do any support services but have opened up divisions to do it. The greater the competitive landscape the more pressure you have on fees."

Whereas once it might have been standard practice to charge for administrative services based on the size of the fund, several industry participants claim to have seen audit-style pricing, based on a projected number of man hours. One manager recalls being quoted a flat fee tied to the number of investors in the fund, with incremental extras dependent on the number of report cycles required and the number of inquiries submitted by LPs. It was a competitive quote but the manager was unconvinced.

"The price pressure makes the margins so thin, they have to scale back, they can't hire good people and the quality of the work drops. It's a vicious circle," he explains. "They generate work that the in-house team then has to correct and return to the administrator before it can be sent to LPs."

Headland had a similar experience. The GP was looking at different PE software systems and spoke to an administrator that was using one of those systems. The outsourcing option was considered as an alternative to building up internal expertise the system.

"In the end, we decided that our internal team using our existing systems could manage all of our requirements for the current funds," says Stewart. "When it comes down to complicated processes such as waterfall distributions, there are no easy fixes and we don't feel comfortable outsourcing that function in particular."

Rebecca Lam, the private equity firm's CFO, adds that Headland currently does outsource custodian services. However, there are not many firms that are capable of fulfilling this function in all of the countries in which the PE firm invests. And while some custodians do offer fund administrative services, it has been decided to keep those functions in-house for now.

Shifting sands

It is a view some fund administrators might contest. They set themselves apart from plain vanilla providers in terms of the range and reach of their services, at the heart of which is an ability to fulfill a variety of functions across numerous jurisdictions. While boutique service providers were appropriate for a boutique community of GPs, institutionalization and the concentration of assets within a smaller number of firms requires global consistency and presence.

"The smaller guys are finding it tough. The sophistication of the managers has gone up and without the specific knowledge or the infrastructure and technology it is it is difficult to go after managers," says Citi's Li, who envisages an industry dominated by a handful of players within a few years. "This business is bricks and mortar, boots on the ground - if you don't have that I don't see how you can survive."

The competitive landscape can be divided up into several categories: broad-based asset servicers exemplified by State Street and Citco; administration units of banks like Citi and HSBC; private equity and real estate specialists such as Tricor IAG, Augentius and Langham Hall; and all manner of generalist independent corporate and fund services providers, including Alter Domus and Intertrust.

Listing the pros and cons of each model is unlikely to produce a definitive winner. Large players highlight scope, scale and the ability to invest in technology. Specialists emphasize the difference between private equity and hedge fund accounting, and question whether clients' needs are met by having both competences under the same roof. The bank units must counter claims that they are non-core parts of much larger businesses.

The broader issue is whether Asian fund managers are ready to buy into the value proposition and consider a third-party administrator in the first place. "Our biggest competitor is a GP choosing not to outsource or retain the functionality in house," observes State Street's McNicholas.

SIDEBAR: FATCA and AIFMD - A value-add opportunity

Two five-letter acronyms are threatening to re-write private equity regulation, particularly in terms of how funds interact with investors. As such, fund administrators, lawyers and accountants have been inundated with requests from GPs for guidance on the US Foreign Account Tax Compliance Act (FATCA) and the EU's Alternative Investment Fund Managers Directive (AIFMD).

FATCA, which requires foreign financial institutions to disclose the identities of foreign investors and account holders to the authorities as part of efforts to prevent capital flight, is currently seen as the more pressing concern of the two, even though the impact remains uncertain.

"FATCA is something everyone is doing and we are currently on track to be compliant by the end of this month," says Stephen Tang, CFO of China-focused GP Lunar Capital Partners. "The full compliance burden hasn't hit us yet - no one really knows how much extra work will be required."

Compliance begins with screening existing investors and establishing which ones fall under the law's jurisdiction; documents must then be prepared and filed with the relevant authorities. The mechanisms are far more advanced than AIFMD, which addresses how managers can market funds in the EU and to whom, but still lacks implementation guidelines in certain jurisdictions.

"We have a lot more discussions around FATCA than around the European directives," says Alexander Traub, managing director for Asia at Augentius. "It is of more concern to GPs. We have built a FATCA product- and give advice on exactly what it means for their investor base. This is an add-on to the administration services we already provide."

Dan McNicholas, head of sector sales for alternatives in Asia at State Street, says his firm is assisting PE clients in preparing their own filings and has also done filings on behalf of others. He recommends managers do the first filing themselves in collaboration with third-party advisors, to ensure they understand the process, and then outsource the function from that point forward.

While an Asian GP could skirt AIFMD completely if it is not raising capital in Europe, FATCA is much harder to avoid.

"Within a matter of a few months, almost every single bank in the world will require a FATCA registration and confirmation that the registration has been made," says Julian Carey, managing director at Tricor IAG.

"There may be no US-sourced investment income and no US investors in the fund, but there is a body of thought that says you will have to go through FATCA registration anyway because a bank won't deal with you unless you have it."

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• Topics
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